Go With the General

Two weeks ago we held the monthly joint web chat for subscribers of The Energy Strategist (TES) and MLP Profits. The chat is conducted by Igor Greenwald, managing editor for TES and chief investment strategist for MLP Profits, and myself.

In the span of just over an hour we received about 90 questions and comments. While we addressed the majority during the chat — with a particular focus on portfolio holdings and recommendations — we still had a fair number of questions remaining at the end. Last week I answered four of the remaining MLP questions, and today I answer three more. (For answers to the remaining chat questions on energy companies outside the MLP space, see this week’s Energy Letter and The Energy Strategist.)

Q: What is offering more value: KMI or KMP? Which would you prefer?

We got a ton of questions in the chat about the relative merits of Kinder Morgan (NYSE: KMI) and Kinder Morgan Energy Partners (NYSE: KMP). Several were answered, but perhaps it would be helpful to summarize our position here. Note that I will not offer specific Buy, Sell, or Hold recommendations here; those are reflected in the current MLP portfolios. Rather I will compare and contrast the two.

To review, Kinder Morgan is the general partner of Kinder Morgan Energy Partners and El Paso Pipeline Partners (NYSE: EPB). Shares/units of KMI, KMP, and EPB have all performed poorly this year relative to competitors, but mostly this is a result of a recent sell-off. The sell-off was prompted by a growth slowdown at KMP and halt of distribution increases at EPB, which was blamed on two adverse rate rulings for different segments of El Paso’s system. This has been extrapolated to a permanent slowdown at KMI, which we believe to be unwarranted.

Kinder Morgan Organizational Structure. Source: Kinder Morgan Investor Presentation

KMP is now expected to increased next year’s distributions by 5 percent over this year’s total, although Kinder Morgan’s conservative forecasting means it will likely top that target. KMI’s dividend is expected to increase 8 percent over 2013 and 10 percent over the target for the current year.  At the current price, that’s a 5.2 percent prospective 2014 yield from a dividend that’s likely to grow at least 10 percent in the years ahead simply from the accretion of incentive distribution rights.

We believe that KMP has less upside than KMI because it will pay an increasing share of its cash flow to KMI as incentive distribution rights, and frankly because it has held up better than KMI to this point. And the past week has shown signs that the recent downside momentum may be starting to reverse, especially with KMI, which advanced by nearly 8 percent for the week.

You also need to take into account the tax implications. As the general partner, KMI is a corporation paying corporate income tax, and issues 1099 tax forms. Thus, many people prefer it for tax-deferred accounts. But a long-term MLP investor interested in a steady stream of income from one of the most reliable names in the business could do a lot worse than KMP.  

Q: The writer before you did not like Dorchester.  Could you research it and give a recommendation by the next chat?

Dorchester Minerals (Nasdaq: DMLP) is a Texas-based partnership that owns producing and non-producing crude oil and natural gas properties, royalty, overriding royalty, net profits, and leasehold interests. The partnership is primarily a natural gas producer, and the biggest knock against it historically is that it hasn’t done a great job of growing proved reserves:

Dorchester Minerals Reserves History. Source: Dorchester Minerals Investor Presentation

Another knock (for some) is that it is a variable-distribution MLP, which isn’t what most MLP investors are generally looking for. MLP investors tend to favor stable distributions that slowly grow over time, but Dorchester’s distributions have been (surprise!) variable and weaker in recent years as a result of low natural gas prices:

Dorchester Minerals Distribution History. Source: Dorchester Minerals Investor Presentation

Nevertheless, the units have performed well: they’re up 22 percent over the past 12 months, which is better than many of Dorchester’s upstream MLP peers. Further, the partnership has been making positive moves in developing more production in liquids-rich gas plays like the Anadarko Basin, and in pursuing primarily oil plays in the Permian Basin and Bakken Formation.

Dorchester has no debt, and an Enterprise Value/EBITDA of 12.8. The yield based on the past 12 months of distributions is 7 percent. As a result of the recovery in natural gas prices and the move toward more lucrative liquids production, Q3 income was up 32 percent year-over-year.

Variable distribution MLPs aren’t for everyone, and investors in these types of MLPs have to be prepared for the occasional correction when distributions fall as a result of market conditions. But for those who understand the risks and can accept the variable income, Dorchester has been an excellent performer, and the future looks even better.    

Q: Please let us know your thoughts on CQP. We assume once the LNG trains start to flow, revenue and dividends will also increase nicely?

Cheniere Energy (NYSE: LNG) is really a remarkable story. Ten years ago predictions of a catastrophic drop in natural gas supply were common, and it was clear that the US would need LNG import terminals to avoid the pending shortfalls in domestic natural gas production. US gas imports were projected to surpass 8 billion cubic feet per day by 2010.

Cheniere Energy saw an opportunity and began to build LNG import terminals, signing up customers like Total and Chevron to 20-year option contracts to import LNG. But the late George P. Mitchell was quietly marrying the technique of hydraulic fracturing, or “fracking” to horizontal drilling, and the US quickly went from natural gas famine to natural gas feast.

Cheniere was pushed to the edge of bankruptcy as interest in LNG imports vanished. Cheniere’s share price fell from $40 to just over $1. But Cheniere evolved with the changing marketplace, and decided to turn its LNG import facility into an LNG export terminal. And because the company had steel in the ground and had already traversed the permitting process, it had a significant lead on competitors. Equity investments came pouring in. New contracts were signed with Total, Korea Gas, India’s GAIL, Spain’s Fenosa and Centrica in the UK.

Cheniere was a first mover, and in 2012 it obtained approval from the Federal Energy Regulatory Commission (FERC) to export LNG to countries that lack a Free Trade Agreement (FTA) with the US. The non-FTA designation is important, because it covers many of the most lucrative LNG markets. Cheniere is the only company to have received the required approvals from both FERC and the US Department of Energy (DOE).

In 2007 Cheniere created the Cheniere Energy Partners (NYSE: CQP) master limited partnership to own assets such as its Sabine Pass LNG export terminal under construction on the Louisiana/Texas border, as well as another LNG terminal in Corpus Christi. Cheniere has signed up a number of LNG customers in Asia and in Europe.

Cheniere’s head start should give it probably a few years with limited competition and strong profitability. The future looks bright. The problem is that high expectations are now priced into both LNG and CQP, and they have become speculative investments. The former may be an acceptable investment for aggressive energy sector investors, but the latter is unlikely to be suitable for most MLP investors.

Cheniere Energy Organization Structure. Source: Cheniere Energy Investor Presentation

CQP is currently yielding just over 6 percent, but it is funding distributions with debt. It is likely to continue digging a hole until LNG exports start, most likely in 2016 when the first two liquefaction trains at the Sabine Pass Liquefaction Project are expected to start operations. Once Trains 3 and 4 come online in 2017, the prospects will look pretty good for some distribution hikes. Cheniere estimates that once all four trains are in operation, there will be ~$3 of annual distributable cash flow (DCF) per unit. At the current unit price, that would be a yield of 10.7 percent.

But that’s nearly four years away. And there is a risk in the longer term that, as more LNG export capacity comes online around the globe, the large price differentials that have made the LNG trade seem so profitable will inevitably shrink. Likewise, major pipeline projects on the drawing board could pose formidable competition for some of the LNG proposals.

Cheniere Energy Partners is up more than 500 percent in the past five years, but only because it had fallen into such a deep hole. Since its 2007 IPO, the unit price is up less than 30 percent because of the steep decline suffered in 2008. CQP doesn’t fit the profile that most MLP investors are seeking, but certainly there will be a lot more press as LNG exports move closer to reality. The price may very well surge higher from here. But if you are searching for safe and steady distributions, there are much better options.  

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